Game Theory for Managers Introduction

Lecture 1 Game Plan „ Introduce the course „ Logistics / expectations „ More examples What is Game Theory? „ Study of rational behavior in situations in which your choices affect others & their choices affect you (so-called “games”) „ Bad news: Knowing game theory does not guarantee winning „ Good news: Framework for thinking about strategic interaction Games We Play „ „ „ „ „ „ „ Driving Penalty Kicks GPA trap Doing the dishes Mean professors Group projects Dating coordination hunter & hunted prisoner’s dilemma war of attrition commitment free-riding hidden information Games Businesses Play „ „ „ „ „ „ „ „ Standards adoption Audits Price wars Standards wars Capacity expansion Pollution abatement External financing FCC spectrum coordination hunter & hunted prisoner’s dilemma war of attrition commitment free-riding hidden information auctions Why Study Game Theory? Because the press tells us to… “As for the firms that want to get their hands on a sliver of the airwaves, their best bet is to go out first and hire themselves a good game theorist.” The Economist, July 23,1994 p. 70 “Game Theory, long an intellectual pastime, came into its own as a business tool.” Forbes, July 3, 1995, p. 62. “Game theory is hot.” The Wall Street Journal, 13 February 1995, p. A14 Why Study Game Theory? Because consultants tell us to: „ John Stuckey & David White – McKinsey Sydney „ Tom Copeland – Monitor Why Study Game Theory? „ Because business leaders tell us to: Raymond W. Smith (Bell Atlantic Chairman during 1990s) “At Bell Atlantic, we’ve found that the lessons of game theory give us a wider view of our business situation and provide us a more nimble approach to corporate planning. We call this system, quite simply, the ‘manage the business’ process.” -- in “Business as war game: a report from the battlefront”, Fortune, Sep. 1996 Why Study Game Theory? „ „ „ Because we can formulate effective strategy… Because we can predict the outcome of strategic situations… Because we can select or design the best game for us to be playing… Prerequisite: 15.010 „ In particular, I assume that you are very comfortable representing games with payoff matrix and/or decision tree „ computing reaction curves „ computing equilibrium given payoff matrix and/or decision tree „ Grading Problem Set „ Strategy Memo „ Real-World Application „ Game Participation „ Final Exam „ 15% 15% 25% 20% 25% Team Assignments Target 3-4 students per team 1. Problem Set 2. Strategy Memo 3. Real-World Application Group Assignments 1. Problem Set: Qwest Bond Swap “Design a debt tender offer to minimize the risk of bankruptcy and maximize shareholder equity.” Group Assignments 2. Strategy Memo: Airline Strategy “American Airlines needs you to assess a plan to extend ‘More Room Throughout Coach’ to the older and smaller Super 80 fleet.” Group Assignments 3. Real-World Application “From your analysis, develop strategy advice for one of the players in the game or for a party interested in the outcome.” a. b. c. d. Mixed Strategies. Sequential / Repeated Games. Strategic Moves. Information. Online Games „ Six online games, prior to: „ Lectures 2,3,4,5,9,10 Participate by midnight before lecture „ No preparation: 5-15 minutes to play „ Results revealed in class „ Graded for participation only „ In-Class Games „ Four in-class games „ „ Lectures 2,3,6,8 Require preparation outside of class 1-2 page worksheet for you to complete and hand in „ graded for participation only „ Final Exam „ Take-home exam Open notes / Open book „ Due at beginning of last class „ Practice exam will be provided „ Wait List & Auditing TA will be managing the wait list „ As a courtesy, please inform the TA „ if you want off the wait list „ if you think there’s 50% or more chance you will drop „ „ No auditors please Outline of Course FOUNDATIONS 1–4 COMMITMENT 5-8 INFORMATION 9-11 Part I: Foundations Introduction 1 Rationality? 2 Prisoners’ Dilemma Loyal Servant Hunter & Hunted 3 Assurance Chicken 4 Part II: Commitment Credibility 5 Strategic substitutes & complements 6 Entry 7 Brinkmanship Negotiation 8 Part III: Information Auctions 9 Signaling Incentives 10 Reputation 11 Game Theory = Interactive Decision Theory „ Decisions •You take the world as given and make the best decision for yourself „ Games •Your best decision depends on what others do, and what they do may depend on what they think you do … Overview 1. 2. 3. Key elements of a game Anticipating others’ behavior Acquiring advantage Key Elements of a Game Players: Who is interacting? „ Strategies: What are their options? „ Payoffs: What are their incentives? „ Information: What do they know? „ Rationality: How do they think? „ How to anticipate others’ behavior in a game „ „ „ „ Evolution: If non-strategic and adaptive, play repeatedly (or observe past play) Dominance: If never play a strategy that is always worse than another Rationalizability: If play optimal given some beliefs about what others play (and what others believe) Equilibrium: If play optimal given correct beliefs about others Themes for acquiring advantage in games 1. Commitment / strategic moves: Credibility, threats, and promises 2. Leveraging limited rationality: Reputation and surprise 3. Exploiting incomplete information: Signaling, selection, and info cascades Cigarette Advertising on TV 1964 „ All US tobacco companies advertised heavily on television „ Surgeon General issues official warning • Cigarette smoking may be hazardous „ Cigarette companies’ reaction • Fear of potential liability lawsuits 1970 „ Companies strike agreement • Carry the warning label and cease TV advertising in exchange for immunity from federal lawsuits. Strategic Interactions „ „ „ Players: Strategies: Payoffs: Reynolds and Philip Morris { Advertise , Do Not Advertise } Companies’ Profits „ Each firm earns $50 million from its customers Advertising costs a firm $20 million Advertising captures $30 million from competitor „ How to represent this game? „ „ Payoff Table PLAYERS Reynolds STRATEGIES No Ad Ad Philip Morris No Ad Ad 50 , 50 20 , 60 60 , 20 30 , 30 PAYOFFS Best responses No Ad Reynolds Ad „ Philip Morris No Ad Ad 50 , 50 20 , 60 60 , 20 30 , 30 Best response for Reynolds: • If Philip Morris advertises: • If Philip Morris does not advertise: advertise advertise „ Advertise is dominant strategy! „ This is another Prisoners’ Dilemma What Happened? „ After the 1970 agreement, cigarette advertising decreased by $63 million „ Profits rose by $91 million „ Why/how were the firms able to escape from the Prisoner’s Dilemma? Changing the Game thru Gov’t-Enforced Collusion? No Ad Reynolds Ad Philip Morris No Ad Ad 50 , 50 20 , 60 60 , 20 30 , 30 „ The agreement with the government forced the firms not to advertise. „ The preferred outcome (No Ad, No Ad) then was all that remained feasible Example: MBA Recruitment „ The message at Sloan orientation: “start looking immediately for a job” „ „ It could be worse: in the 1920’s, people admitted to Law School were being offered clerkships before ever setting foot on campus Why does recruitment start so early? Vicious Cycle of Adverse Selection „ Early-moving firms will hire students who tend to be above-average „ The remaining population of students is on average worse than before, which increases the incentive to move early! „ Why doesn’t Sloan administration act as thirdparty enforcer to allow us to escape this Prisoners’ Dilemma? Third-Party Enforcement? „ Firms and students have no incentive to report an early hire, if this will be punished „ „ No way for Sloan to be effective enforcer since it can’t identify deviants Does this mean that “unraveling” is inevitable in the MBA recruitment market? Jump the Gun or Not? „ Downside of moving early: firm gets less precise information about student quality „ Upside of moving early: more students are available to be hired „ Jumping the gun is not a dominant strategy if downside outweighs upside. For example: „ „ students can provide strong signals while in school students outnumber job openings Strategies for Studying Games „ Two general approaches „ Case-based • Pro: Relevance, connection of theory to application • Con: Generality „ Theory • Pro: General principle is clear • Con: Applying it may not be Approach of this course „ „ „ Between theory and cases Lectures organized around general principles Illustrated with cases and game-playing „ „ Cases are “stripped down” to essentials Frequent reality checks „ „ „ When does theory work? When doesn’t it? Why doesn’t it? The Uses of Game Theory „ Explanatory „ „ Predictive „ „ A lens through which to view and learn from past strategic interactions With many caveats Prescriptive „ The main thing you’ll take out of the course is an ability to think strategically Online Game #1 Play Online Game #1 prior to midnight before next lecture. „ Follow instructions on handout „ Sign up / create password on game site „ Then play the game (no preparation) „ In-Class Game Next Time „ Prepare for “Urn Game” to be played in class next lecture. „ See handout